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Article | McKinsey Quarterly

When and when not to vertically integrate

A strategy as risky as vertical integration can only succeed when it is chosen for the right reasons.
August 1993 | by John Stuckey and David White

V ertical integration is a risky strategy complex , ex pensiv e, and hard to rev erse. Y et some companies jump into it without an adequate analy sis of the risks. This article dev elops a framework to help managers decide when it is useful to v ertically integrate and when it is not. It ex amines four common reasons to integrate and warns managers against a number of other, spurious reasons. The primary message: don't v ertically integrate unless it is absolutely necessary to create or protect v alue. V ertical integration can be a highly important strategy , but it is notoriously difficult to implement successfully andwhen it turns out to be the wrong strategy costly to fix . Management's track record on v ertical integration decisions is not good. This article is intended to help managers make better integration decisions. It discusses when to v ertically integrate, when not to integrate, and when to use alternativ e, quasi-integration strategies. Finally , it presents a framework for making the decision.
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When to integrate
"V ertical integration" is simply a means of coordinating the different stages of an industry chain when bilateral trading is not beneficial. Consider hot-metal production and steel making, two stages in the traditional steel industry chain. Hot metal is produced in blast furnaces, tapped into insulated ladles, and transported in molten form at about 2,500 degrees perhaps 500 y ards to the steel shop, where it is poured into steel-making v essels. These two processes are almost alway s under common ownership, although occasionally hot metal is traded; for sev eral months in 1 991 , Weirton Steel sold hot metal to Wheeling-Pittsburgh, almost ten miles away . Such trading is rare, howev er. The fix ed asset technologies and frequency of transactions would dictate a market structure of tightly bound pairs of buy ers and sellers that would need to negotiate an almost continuous stream of transactions. Transaction costs and the risk of ex ploitation would be high. It is more effectiv e, lower cost, and lower risk to combine these two stages under common ownership. Ex hibit 1 lists the kinds of costs, risks, and coordination issues that should be weighed in the integration decision. The tough part is that these criteria are often at odds with each other. V ertical integration ty pically reduces some risks and transaction costs, but it requires heav y setup costs, and its coordination effectiv eness is often dubious.

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Exhibit 1
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There are four reasons to v ertically integrate: The market is too risky and unreliableit "fails"; Companies in adjacent stages of the industry chain hav e more market power than companies in y our stage; Integration would create or ex ploit market power by raising barriers to entry or allowing price discrimination across customer segments; or The market is y oung and the company must forward integrate to dev elop a market, or the market is declining and independents are pulling out of adjacent stages. Some of these are better reasons than others. The first reasonv ertical market failureis the most important one.
Vertical market failure

A v ertical market "fails" when transactions within it are too risky and the contracts designed to ov ercome these risks are too costly (or impossible) to write and administer. The ty pical features of a failed v ertical market are (1 ) a small number of buy ers and sellers; (2) high asset specificity , durability , and intensity ; and (3) frequent transactions. In addition, broader issues that affect all marketsuncertainty , bounded rationality , and opportunismplay a special part in a failed v ertical market. None of these features, taken indiv idually , necessarily signifies a v ertical market failure (V MF), but when they are all present, chances are good the market has failed. Buy ers and sellers. The number of buy ers and sellers in a market is the most criticalalthough the least permanentv ariable determining V MF. Problems arise when the market has only one buy er and one seller (bilateral monopoly ) or only a few buy ers and a few sellers (bilateral oligopoly ). Ex hibit 2 illustrates the possible market structures.

Exhibit 2
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Microeconomists hav e realized that rational supply and demand forces alone do not set transaction prices and v olumes deterministically in such markets, as they do in all other v ertical market structures. Rather, the terms of transactions, especially price, are determined by the balance of power between buy ers and sellersa balance that is unpredictable and unstable. Where there is only one buy er and one supplier (especially in long-term relationships that inv olv e frequent transactions), each attempts to lev erage its monopoly status. As commercial conditions change unpredictably ov er time, this leads to a lot of haggling and attempts at ex ploitation, which are costly and risky . Bilateral oligopolies hav e especially complex coordination problems. If, for ex ample, there are three suppliers and three customers, each play er sees fiv e other play ers with whom the collectiv e economic surplus must be shared. If play ers are not careful, they will collectiv ely compete away all the surplus and pass it along to customers. In order to av oid this, they might try to create monopolies at each stage of the chain, but anti-trust laws prev ent them. So play ers merge v ertically , creating, in this case, three play ers instead of six . When each then sees only two other play ers seeking slices of the surplus, they hav e a better chance of behav ing rationally . We relied on this concept to adv ise a company on whether to continue to run an in-house shop that supplied machining serv ices to the company 's steel plant. An analy sis showed that the shop was v ery costly , relativ e to outside contractors. Some managers wanted to close the shop. Others countered that this would leav e the plant v ulnerable to disruptions; there was a small number of potential outside suppliers, including only one heav y machine shop within 1 00 kilometers. We recommended that the shop be closed if it failed to be competitiv e on scheduled work and most light machining jobs. This work was predictable, used standardized machines, and could be done by sev eral outside suppliers. Therefore, it was low risk and had low transaction costs. Howev er, we recommended that a slimmed-down heav y machine shop be maintained in-house for breakdown work requiring v ery large lathes and v ertical borers. This work was unpredictable, only one local outside supplier could prov ide it, and the costs of any delay in bringing the plant back on stream were enormous. Assets. If this combination of problems occurs only in bilateral monopolies or close-knit bilateral oligopolies, aren't we just talking about an oddity with infrequent practical significance? No. Many v ertical markets that appear to hav e numerous play ers on each side are, in effect, composed of groups of bilateral oligopolists tightly bound together. The groupings arise because asset specificity , durability , and intensity raise switching costs to the point where only a small segment of the apparent univ erse of buy ers is truly av ailable to the sellers, and v ice v ersa. There are three principal ty pes of asset specificity that compartmentalize industries into bilateral monopolies and oligopolies. Site specificity occurs when buy ers and sellers locate fix ed assets, such as a coal mine and power station, in close prox imity to minimize transport and inv entory costs. Technical specificity occurs when one or both parties to a transaction inv est in equipment that can only

be used by one or both parties and that has low v alue in alternativ e uses. Human capital specificity occurs when employ ees dev elop skills that are specific to a particular buy er or customer relationship. The upstream aluminum industry has high asset specificity . This industry has two principal stages of production: baux ite mining and alumina refining. Mines and refineries are usually located close together (site specificity ) because of the high cost of transporting baux ite, relativ e to its v alue, and the 60 percent to 7 0 percent v olume reduction ty pically achiev ed during refining. Refineries are tailored to process their own baux ite, with its unique chemical and phy sical properties; switching suppliers or customers is either impossible or prohibitiv ely ex pensiv e (technical specificity ). Consequently , mine-refinery pairs are locked together economically . These bilateral monopolies ex ist despite the apparent presence of dozens of buy ers and sellers. In fact, the pre-inv estment phase of the transaction relationship between a mine and a refinery does not suffer from bilateral monopoly . A number of baux ite miners and alumina refiners around the world line up and bid whenev er a greenfield mine and refinery are in the offing. Howev er, the market quickly becomes a bilateral monopoly in the post-inv estment phase. The miner and the refiner who ex ploit the greenfield opportunity are locked together economically by asset specificity . Because industry participants realize the perils of V MF, the mine and the refinery usually end up under common ownership. Around 90 percent of baux ite transactions occur under v ertical integration or quasi-v ertical arrangements, such as joint v entures. Auto assemblers and their component suppliers can also be locked together, as when a component is specific to a particular make and model. When the amount of research and dev elopment (R&D) inv estment in the component is high (asset intensity ), it is risky for the component supplier and auto assembler to be independent. Either side is v ulnerable to opportunistic recontracting, especially if, for ex ample, the model is a surprising success or failure. To av oid the dangers of bilateral monopolies and oligopolies in such cases, auto assemblers tend to backward integrate or, following the ex ample of the Japanese, enter into close-knit contractual arrangements with carefully chosen supplierswhere the strength of relationships and contracts prev ents risks of opportunistic ex ploitation inherent in arm's length sales between "compatible" parties. Post-inv estment phase bilateral monopolies and oligopolies caused by asset specificity are the most frequent cause of V MF. The effect of asset specificity is magnified when the assets are also capital intensiv e and durable and when they giv e rise to high fix ed-cost structures. While the ex istence of a bilateral oligopoly increases the risk of supply or outlet disruption, high capital intensity and high fix ed costs increase the costs of any production disruption because of the magnitude of both cash and opportunity costs incurred during the interruption. Asset durability increases the time horizon ov er which the risks and costs are relev ant. Taken together, high asset specificity , intensity , and durability often cause high switching costs for both suppliers and customers. Their presence is one of the most important contributing factors to decisions to v ertically integrate across a wide range of industries. Transaction frequency. High transaction frequency is another factor that will promote V MF, when it is accompanied by bilateral oligopolies and high asset specificity . Frequent transactions raise costs for the simple reason that haggling and negotiating occur more often and allow for frequent ex ploitation. Ex hibit 3 plots transaction frequency and asset characteristics on a matrix that suggests appropriate v ertical coordination mechanisms. When buy ers and sellers seldom need to interact, v ertical integration is usually not necessary , whether asset specificity is low or high. When asset specificity is low, markets can operate effectiv ely using standard contracts such as leases and credit sale agreements. And when asset specificity is high, the contracts may be quite complicated but integration is still not necessary . An ex ample would be major public construction projects.

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Ev en if transaction frequency is high, low asset specificity will mitigate its effects. For ex ample, trips to the grocery store don't usually require complicated negotiations. But when assets are specific, durable, and intensiv e, and transactions are frequent, v ertical integration is likely to be warranted. Otherwise, transaction costs and risks will be too high, and complete contracts to eliminate these uncertainties will be difficult to write. Uncertainty , bounded rationality , and opportunism . Three additional factors hav e subtle but important implications for v ertical strategy . Uncertainties make it difficult for companies to draw up contracts that will guide them as circumstances change. In the machine shop ex ample, the major uncertainties included the timing, nature, and sev erity of plant breakdowns and the supply and demand balance in the local markets for machining serv ices. With such a high lev el of uncertainty , the company was better off maintaining its in-house shop for breakdown work. The work will proceed more smoothly , cheaply , and with a lower risk if this part of the chain is integrated. Bounded rationality also inhibits companies from writing contracts that fully describe transactions under all future possibilities. This concept, formalized by economist Herbert Simon, is that human beings hav e a limited ability to solv e complex problems. One of Simon's students, Oliv er Williamson, noted the effect of bounded rationality on market failure.
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Williamson also introduced the notion of opportunism : when giv en the chance, people will often cheat and deceiv e in commercial dealings when they perceiv e that it is in their long-term interest to do so. Uncertainty and opportunism can often be seen to driv e v ertical integration outcomes in the markets for R&D serv ices and the markets for new products and processes generated by R&D. These markets often fail because the end product of R&D is largely information about new products and processes. In a world of uncertainty , the v alue of new products and processes to a purchaser is not known until it has been observ ed. But the seller is reluctant to disclose information before pay ment because a prev iew could giv e the product away . The situation is ripe for opportunism. When specific assets are required in the dev elopment and application of the new ideas or when the originator cannot protect its property rights through patents, companies will probably benefit from v ertical integration. For buy ers that would mean dev eloping their own R&D departments; for sellers that would mean forward integrating. For ex ample, EMI, the dev eloper of the first CAT scanner, should hav e forward integrated into specialized distribution and serv icing, as producers of sophisticated medical equipment ty pically do. But it did not hav e these assets at the time, and they are slow and costly to build. General Electric and Siemens, which were integrated across R&D, engineering, and marketing, rev erseengineered the scanner, improv ed on it, prov ided more training, support, and serv icing, and captured the major share of the market. While uncertainty , bounded rationality , and opportunism are ubiquitous, they do not alway s hav e the same intensity . This observ ation may ex plain some
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interesting patterns in v ertical integration across countries, industries, and time. For ex ample, Japanese manufacturers in industries like steel and autos are less backward integrated into supplier industries, such as components and engineering serv ices, than are their Western counterparts. Instead, they rely on relativ ely few contractors with whom they enjoy fairly stable, nonadv ersarial relationships. One of the possible reasons that contributes to Japanese manufacturers' willingness to rely on outsiders is that opportunism is not as rife in Japanese culture as it is in Western culture.
Defending against market power

V ertical market failure is the most important reason to v ertically integrate. But companies sometimes integrate because a company in an adjacent stage of the industry chain has more market power. If one stage of an industry chain ex erts market power ov er another and thereby achiev es abnormally high returns, it may be attractiv e for participants in the dominated industry to enter the dominating industry . In other words, the industry is attractiv e in its own right and might attract prospectiv e entrants from both within the industry chain and outside it. The Australian ready -mix concrete industry is notoriously competitiv e because there are low barriers to entry and because there is cy clical demand for what is essentially a commodity product. Participants often engage in price wars and generally earn low returns. By contrast, the quarry industry , which supplies sand and stone to the ready -mix manufacturers, is ex tremely profitable. Limited quarry sites in each region and high transport costs from other regions create high barriers to entry . The few play ers, recognizing their mutual interests, charge prices well abov e what would occur in a competitiv e marketplace and earn an attractiv e economic surplus. These high-priced quarry products are an important input cost for ready -mix concrete. Therefore, the concrete companies hav e backward integrated into quarries, largely v ia acquisitions, and now three large play ers control about 7 5 percent of both the concrete and quarry industries. It is important to note that entry v ia acquisitions will not create v alue for the acquirer if it has to hand ov er the capitalized v alue of the economic surplus in the form of an inflated acquisition price. Often, the ex isting play ers in the less powerful stages of an industry chain pay too much for businesses in the powerful stages. In the Australian concrete business, at least some of the quarry acquisitions would seem to hav e destroy ed v alue for the acquirer. Recently one of the large concrete makers acquired a small, integrated quarry ing and concrete-making operator at an inferred price/cashflow multiple of twenty . It is v ery difficult to justify such a premium, giv en that the acquirer's real cost of capital is about 1 0 percent. While play ers in weak stages of an industry chain hav e clear incentiv es to mov e into the powerful stages, the key issue is whether they can achiev e integration at a cost less than the v alue of the benefits to be achiev ed. Unfortunately , in our ex perience, they often cannot. Managers often mistakenly believ e that, as an ex isting play er in the industry , their entry into a more attractiv e business within the chain is easier than it is for outsiders. Howev er, the key skills along an industry chain usually differ so substantially that outsiders with analogous skills from other industries are often superior entrants. (Outsiders, too, can dissipate the stage's v alue; if one firm can scale the barriers and enter the attractiv e stage, other new entrants may be able to do the same.)
Creating and exploiting market power

V ertical integration also makes strategic sense when used to create or ex ploit market power. Barriers to entry . When most competitors in an industry are v ertically integrated, it can be difficult for nonintegrated play ers to enter. Potential entrants may hav e to enter all stages to compete. This increases capital costs and the minimum efficient scale of operations, thus raising barriers to entry . One industry where v ertical integration added to entry barriers was the upstream aluminum industry . Until the 1 97 0s, the industry 's three stagesbaux ite mining, alumina refining, and metal smeltingwere dominated by the six v ertically integrated majors: Alcoa, Alcan, Pechiney , Rey nolds, Kaiser, and Alusuisse. The markets for the intermediate products, baux ite and alumina, were too thin for a nonintegrated trader. Ev en integrated entrants were repelled by the $2 billion price tag (in 1 988 figures) for efficient-scale entry as a v ertically integrated play er.

Ev en if this barrier could be scaled, an entrant would need to find immediate markets for the roughly 4 percent it would be adding to world capacity not an easy task in an industry growing at about 5 percent annually . Not surprisingly , the v ertical integration strategies of the majors were the predominant cause of the industry 's sizable barriers to entry . Similar entry barriers ex ist in the automobile industry . Auto manufacturers are usually forward-integrated into distribution and franchised dealerships. Those with strong dealer networks tend to hav e ex clusiv e dealerships. This means that new entrants must establish widespread dealer networks, which is ex pensiv e and time consuming. Without their "inherited" dealer networks, manufacturers like General Motors would hav e lost more market share than they already hav e to the Japanese. Using v ertical integration to build entry barriers is often, howev er, an ex pensiv e ploy . Furthermore, success is not guaranteed, as inv entiv e entrants ultimately find chinks in the armor if the economic surplus is large enough. For ex ample, the aluminum companies ev entually lost control of their industry , mainly as a result of new entrants using joint v entures. Price discrim ination. Forward integration into selected customer segments can allow a company to benefit from price discrimination. Consider a supplier with market power that sells a commodity product to two customer segments with different price sensitiv ities. The supplier would like to max imize its total profits by charging a high price to the price-insensitiv e segment and a low price to the pricesensitiv e segment, but it cannot do so because the low-price customers can resell to the high-price customers and, ultimately , undermine the entire strategy . By forward-integrating into the low price segment, the supplier prev ents reselling. There is ev idence that the aluminum companies hav e forward-integrated into fabrication segments with the most price-sensitiv e demands (such as can stock, cable, and automobile castings) and hav e resisted integration into segments where the threat of substitution is low.
Responding to industry life cycle

When an industry is y oung, companies sometimes forward-integrate to dev elop a market. (This is a special case of v ertical market failure.) During the early decades of the aluminum industry , producers were forced to forward-integrate into fabricated products and ev en end-product manufacture to penetrate markets that traditionally used materials such as steel and copper. The early manufacturers of fiberglass and plastic, too, found that forward integration was essential to creating the perception that these products were superior to traditional materials.
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Howev er, our ex perience suggests that this rationale for forward integration is ov errated. It is successful only when the downstream business possesses proprietary technology or a strong brand image that prev ents imitation by "free rider" competitors. There is no point in dev eloping new markets if y ou cannot capture the economic surplus for at least sev eral y ears. Also, market dev elopment will be successful only if the product has some real adv antages ov er its current or potential substitutes. When an industry is declining, companies sometimes integrate to fill the gaps left by the independents that are pulling out. As an industry declines, weaker independents ex it, leav ing core play ers v ulnerable to ex ploitation by increasingly concentrated suppliers or customers. For ex ample, after the US cigar industry began to decline in the mid-1 960s, Culbro Corporation, a leading US supplier, had to acquire distribution companies in key markets along the east coast. Its major competitor, Consolidated Cigar, was already forward-integrated, and Culbro's distributors had "lost interest" in cigars and were giv ing priority to numerous other product lines.
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When not to integrate

Do not v ertically integrate unless absolutely necessary . This strategy is too ex pensiv e, risky , and difficult to rev erse. Sometimes v ertical integration is necessary , but more often than not, companies err on the side of ex cessiv e integration. This occurs for two reasons: (1 ) decisions to integrate are often based on spurious reasons and (2) managers fail to consider the rich array of quasiintegration strategies that can be superior to full integration in both benefits and costs.
Spurious reasons

The reasons used to justify v ertical integration strategies are often shallow and inv alid. Objectiv es like "reducing cy clicality ," "assuring market access," "mov ing into the high v alue-added stage," or "getting closer to customers" are sometimes v alid, but often not. Reducing cy clicality or v olatility in earnings. This is a common but rarely v alid reason for v ertical integrationa v ariation on the old theme that internal portfolio div ersification is v aluable to shareholders. This argument is inv alid for two reasons. First, returns in contiguous stages of an industry chain are often positiv ely correlated and are subject to many of the same influences, such as changes in demand for the end product. Hence, combining them into one portfolio has little impact on total portfolio risk. This is the case in the zinc mining and zinc smelting businesses, for ex ample. Second, ev en if returns are negativ ely correlated, the smoothing of corporate earnings is not all that v aluable to shareholders, who can div ersify their own portfolios to reduce unsy stematic risk. V ertical integration in this case adds v alue for managers but not for shareholders. Assuring supply or outlets. Owning captiv e supply sources or outlets, it is argued, eliminates the possibility of market foreclosure or unfair prices and insulates companies from short-run supply and demand imbalances in intermediate product markets. V ertical integration can be justified where the possibility of market foreclosure or "unfair" prices is a sy mptom of V MF or of structural market power held by suppliers or customers. But where there is an efficient market, it is not necessary to own supply or outlets. A market participant will alway s be able to trade any v olume at the market price, ev en though the price might seem "unfair" relativ e to costs. A firm that is integrated across such a market only deludes itself when it sets internal transfer prices that are different from market prices. It may ev en make suboptimal output and capacity decisions if integrated for this reason. The subtle, although critical, factors that determine when to assure supply or outlets are the structures of the buy ing and selling sides of the market. If both sides are competitiv ely structured, integration does not add v alue. But if the structural conditions giv e rise to V MF or a permanent power imbalance, integration may be justified. Sev eral times we hav e observ ed the interesting case where a group of oligopolists that supply a low-growth commodity product to a reasonably fragmented, lowpower buy ing industry use forward integration to av oid price-based competition. The oligopolists understand that competing for market share on the basis of price is folly , ex cept perhaps in the v ery short run, but they cannot resist the urge to steal market share. Hence, they forward integrate to secure all of their large purchasers. Such behav ior is rational so long as price competition is av oidedand so long as the oligopolists do not pay acquisition prices for downstream customers that are abov e their standalone net present v alues. This sort of forward integration makes sense only when it helps preserv e oligopoly profits in the upstream stage of an industry chain in which a permanent power imbalance ex ists. Capturing m ore v alue. The popular prescription that firms should mov e into the high v alue-added stages of an industry chain is often combined with another sacred belief of the 1 980sthat firms should mov e closer to their customers. Both prescriptions lead to increased v ertical integration, usually forward integration toward final customers. Although there probably is a positiv e correlation between the profitability of a stage in an industry chain and both its absolute v alue added and its prox imity to final consumers, we believ e the correlation is weak and inconsistent. V ertical integration strategies based on these assumptions usually destroy shareholder wealth. It is economic surplus not v alue added or closeness to the customerthat driv es superior returns. Economic surplus is the return an enterprise receiv es in ex cess of its full costs of being in the business, including a fair return on capital. It is merely coincidental if the surplus arising in one stage of an industry chain is proportional to its v alue added (defined as the sum of full cost and surplus, less the cost of inputs sourced from the preceding stage in the industry chain). Howev er, economic surplus is more likely to arise close to the customer because there, according to economists, y ou can get y our hands directly on any av ailable consumer surplus.

The general prescription should therefore be: Integrate into those stages of the industry chain w here the greatest economic surplus is available, irrespective of closeness to the customer or the absolute size of the value added. Recall, though, that the consistently high-surplus stages must, by definition, be protected by barriers to entry , and the v ertically integrating entrant must be able to scale those barriers at a cost less than the v alue of the surplus av ailable. Usually the barriers to entry include the skills required to run the new business, and the entrant often does not possess those skills despite ex perience in an adjacent stage of the industry chain. Consider the Australian cement and concrete industry chain (see Ex hibit 4). Economic surplus is not proportional to the v alue added in the indiv idual stages of production. In fact, the highest v alue-added stage, transport, does not ev en earn an adequate return on capital, whereas the smallest v alue-added stage, fly ash, earns a high economic surplus. Also, economic surplus is not concentrated at the customer end but, if any thing, occurs upstream. In fact, our ex perience suggests that the pattern of economic surplus along industry chains is highly v ariable and needs ex amination on a case-by -case basis.

Exhibit 4
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Quasi-integration strategies

Managers sometimes ov erintegrate because they fail to consider the rich array of quasi-integration strategies av ailable. Long-term contracts, joint v entures, strategic alliances, technology licenses, asset ownership, and franchising tend to inv olv e lower capital costs and greater flex ibility than v ertical integration. Also, they often prov ide adequate protection from V MF and market power held by customers or suppliers. Joint v entures and strategic alliances, for ex ample, allow firms to ex change certain goods, serv ices, information, or ex pertise while maintaining a formal trade relationship on others. Such mechanisms also allow the companies inv olv ed to retain their corporate identities and to av oid the risk of antitrust prosecution. The potential mutual adv antages can be max imized, and the natural conflict in trade relationships can be minimized. For these reasons, a majority of the upstream aluminum industry 's plants are now joint v entures. These structures facilitate the ex changes of baux ite, alumina, technical know-how, and nation-specific knowledge; prov ide forums for oligopolistic coordination; and manage relations between global corporations and host-country gov ernments. Asset ownership is another quasi-integration arrangement. The host firm retains ownership of the critical assets in adjacent stages of the industry chain but contracts out all other aspects of ownership and control in these adjacent stages. For ex ample, assemblers of products like motor v ehicles and steam turbines own

the specialized tools, dies, jigs, patterns, and molds that are unique to their key components. They contract with suppliers for the actual manufacture of components but protect themselv es from opportunistic ex ploitation by owning the assets. Asset ownership is often all that is needed to thwart the opportunism associated with phy sical capital. Similar arrangements are also possible on the downstream side. Franchises allow the host enterprise to control distribution without the drain on capital and management resources that full integration would require. Here, the host firm av oids ownership of the phy sical assets, as they are not especially specific or durable, but retains property rights on the intangible "brand" assets. By holding the right to cancel franchises, the host firm can control standards, as McDonald's does with quality , serv ice, cleanliness, and v alue. Licensing arrangements should alway s be considered as an alternativ e to v ertical integration where buy ing and selling of technology is concerned. Markets for R&D and technology are prone to failure because it is difficult for innov ators to protect their property rights. Often an innov ation is v aluable only when joined with specialized complementary assets, such as skilled marketing or serv ice teams. Licensing may be the answer. Ex hibit 5 is a decision-making framework for the innov ator of a new technology or product. It shows, for ex ample, that when the innov ator is protected from imitators by a patent or trade secret and specific complementary assets either are not critical or are av ailable in competitiv e supply , the innov ator should license to all comers and price for the long run. This strategy ty pically applies to industries like petrochemicals and cosmetics. As copy ing becomes easier and complementary assets more critical, v ertical integration may be required, as illustrated earlier by the CAT scanner ex ample.

Exhibit 5
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Changing vertical strategies

Companies should change their v ertical integration strategies when market structures change. The structural factors most likely to change are the number of buy ers and sellers and the importance of specialized assets. Of course, a company should also alter its strategy , ev en in the absence of structural change, when that strategy turns out to be wrong.
Buyers and sellers

In the mid-1 960s, the crude oil market ex hibited all the features of a v ertically failed market (see Ex hibit 6). The top four sellers accounted for 59 percent of industry sales and the top eight accounted for 84 percent. The buy ing side was equally concentrated. The number of relev ant buy er-seller combinations was further reduced because refineries were geared to process specific ty pes of crude.

The assets were highly capital intensiv e and long liv ed, transactions were frequent, and the need for continuous plant optimization increased the lev el of uncertainty . Not surprisingly , there was almost no spot market, and most transactions were conducted in-house or through ten-y ear fix ed contracts in order to av oid the transaction costs and risks of trading on an unreliable, v ertically failed market.

Exhibit 6
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Howev er, ov er the past twenty y ears, there hav e been fundamental shifts in underly ing market structure. The nationalization of oil reserv es by OPEC producers (replacing the "Sev en Sisters" with multiple national suppliers), combined with the huge growth of non-OPEC suppliers such as Mex ico, has reduced seller concentration enormously . By 1 985, the market share of the top four sellers had fallen to only 26 percent and the top eight to 42 percent. Concentration of refinery ownership had also fallen substantially . Furthermore, technological adv ances hav e reduced asset specificity by allowing modern refineries to process a much wider range of crudes with much lower switching costs. The increase in the number of buy ers and sellers and the decrease in switching costs hav e greatly reduced the need for v ertical integration by allowing the dev elopment of an efficient market for crude oil. It is estimated that around 50 percent of transactions are now traded on the spot market (ev en by the large, integrated play ers), and there is a growing number of nonintegrated play ers.
Disintegration

Three forces seem to fav or a general trend toward v ertical disintegration during the 1 990s. First, many companies integrated in the past for spurious reasons and should now, ev en in the absence of structural change, disintegrate. Second, the emergence of a powerful market for corporate control is increasing pressure on ov erintegrated companies to restructure themselv eseither v oluntarily or at the hands of corporate raiders. And third, worldwide structural changes are occurring in many industries that increase the adv antages and reduce the risks of trading. The first two reasons are self-ex planatory , but the third reason needs elaboration. In many industry chains, the costs and risks of trading hav e been reduced by increases in the number of buy ers or sellers or both. Industries such as telecommunications and banking are being deregulated to allow the entry of new play ers into national monopolies and oligopolies. Also, growth of the newly industrialized countries, including Korea, Taiwan, Hong Kong, and Mex ico, has greatly increased the univ erse of potential suppliers in many industries, such as consumer electronics. Similarly , the globalization of consumer markets and the pressures on indiv idual

firms to become "insiders" in each national market they serv e are prompting many companies to build new manufacturing facilities in countries to which they prev iously ex ported. This, of course, increases the number of components buy ers. The growing need for manufacturing flex ibility and corporate focus is another force that reduces the costs and increases the benefits of trading. For an auto manufacturer that assembles thousands of components, each of which may be characterized by increasing technological complex ity and by shortening product life cy cles, it is difficult to maintain ex cellence in all areas. Purchasing from specialist suppliers and focusing on design and assembly can prov ide benefits. In addition, managers hav e become more ex perienced and comfortable with quasi-integration techniques such as long-term preferred supplier relationships. In many industries, purchasing departments hav e transformed their adv ersarial stance toward suppliers into a cooperativ e one. The US car industry , for ex ample, is reducing its lev el of v ertical integration and the number of suppliers to concentrate on establishing fewer, more cooperativ e independent supply agreements. Working against these forces, howev er, is a trend toward consolidation. As conglomerates like Beatrice Foods are disaggregated, the pieces are finding their way into the hands of companies that use them to increase their own shares of particular markets. Our ex periences suggest, howev er, that the forces promoting globally competitiv e industry structures are generally winning out. In addition to the pressures to disintegrate industry chains, there are pressures on firms to disintegrate the business sy stems within their own stages. Low-cost foreign competitors are pressuring corporations to be more cost effectiv e. Adv ances in information and communications technologies are reducing the costs of bilateral trading. Although these forces tend to fav or industry chain and business sy stem disintegration, a word of warning is warranted. Our suspicion is that some managers, caught up with the zest to "downscale," "be like the Japanese," or "take a nonadv ersarial approach to suppliers," will end up throwing a few babies out with the bathwater. They will disintegrate some activ ities that are in fact critical because of V MF; they will form some strategic alliances that turn out to be institutionalized piracy ; and they will find that "cooperativ e" sole suppliers hav e not forgotten how to flex their muscles after their competing suppliers hav e been thoroughly banished. In all cases, decisions to integrate or disintegrate should be analy tical rather than fashionable or instinctual. To that end, we hav e dev eloped a step-by -step v ertical restructuring framework (see Ex hibit 7 ). The key point, again, is this: do not v ertically integrate unless absolutely necessary .

Exhibit 7
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Using the framework

We hav e successfully applied this framework in a number of situations where clients were try ing to resolv e make/buy decisions, such as the following: Should a steel plant retain all parts of its machine shop?

Should a large ex ploration and mining company hav e its own legal department or use outside law rms? Should a bank produce its own checkbooks or contract the task to outside printers? Should a telecommunications company with 90,000 employ ees hav e its own in-house training unit or use outside trainers? We hav e also used it to study strategic issues, such as the following: Which parts of a retail bank's business sy stem (for ex ample, product dev elopment, branch network, ATM network, and central computer processing) should it own? What mechanisms should a gov ernment-owned research organization use to trade its serv ices and knowledge with priv ate industry customers? Should a miner and metals processor forward-integrate into metals fabrication? What mechanisms should an agribusiness company use to penetrate the Japanese imported beef market? Should a brewer div est its network of "tied" pubs? Should a natural gas producer integrate downstream into pipelines and power generation?
Process

The process described in Ex hibit 8 largely speaks for itself, but sev eral points are worth emphasizing. First, where major strategic decisions are being made, companies should work hard to quantify the v arious factors. For ex ample, it is usually critical to quantify the switching costs y ou would face if y ou became locked into a supply arrangement by inv esting in the assets specific to that arrangement. Similarly , y ou should quantify the transaction costs incurred when buy ing from or selling to third parties.

Exhibit 8
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Second, most v ertical integration analy ses require an understanding of the behav ior of small groups of buy ers and sellers. Tools like supply and demand analy sis help scope the set of feasible behav ior, but cannot be used to predict behav ior deterministically , as they can in more competitiv e market structures. Predicting competitor behav ior and determining optimal strategy often requires the use of such techniques as pay -off matrices and competitiv e games. This sort of problem solv ing is as much art as science, and we hav e found that it is critical for senior ex ecutiv es to hav e hands-on inv olv ement in it so that they understand and believ e the assumptions about competitor behav ior that must often be made. Third, the process is analy tically demanding and time consuming if followed comprehensiv ely . An initial rapid pass through the steps can help identify key issues and generate hy potheses. This approach allows subsequent in-depth analy sis to be highly focused.

Fourth, prospectiv e users should ex pect a lot of resistance. V ertical integration issues seem to be one of the last bastions within business strategy where gut feel and tradition reign supreme. We hav e found no magic solutions to this problem, but one approach is to find ex amples of other companies in y our industry , or in analogous industries, that illustrate y our thesis. Another idea is to attack faulty logic head on by decomposing it and rev ealing its weak links. Inv olv ing ev ery one in the problem solv ing itself is probably the most effectiv e approach of all. V ertical integration is a difficult strategy . It is usually costly and long liv ed, hence risky . It is not surprising, therefore, that some managers get it wronga problem for them, but an opportunity for insightful and bold strategists adept at ex ploiting others' mistakes.
About the authors John Stuckey is a director and David White a principal in McKinsey's Sydney office. This article is reprinted from the Sloan Management Review, Spring 1993, pp. 7183, by permission of the publisher. Copyright 1993 by the Sloan Management Review Association. All rights reserved.

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